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The Peter Lynch Approach: Investing in "Understandable" Stocks

by Wayne A. Thorp, CFA

The Peter Lynch Approach: Investing In

Outside of Warren Buffett, perhaps no other investment “guru” is better known than Peter Lynch, the manager of Fidelity’s Magellan Fund from 1977 to 1990.

During his tenure at Fidelity, Mr. Lynch honed his bottom-up approach to stock selection, focusing on fundamental analysis that emphasizes a thorough understanding of the company, its prospects, its competitive environment, and whether the stock can be purchased at a reasonable price.

Mr. Lynch outlined his strategy in his books “One Up on Wall Street” and “Beating the Street,” in which he described how his own approach could be used by individual investors.

Mr. Lynch advocated a search for “story” stocks—investing in companies familiar to you, or whose products are relatively easy to understand. The more familiar you are with a company, Mr. Lynch feels, the better you understand the business and its competitive nature, which gives you a better chance of finding stocks with a good “story”—future prospects which, if they unfold according to the plot line, will result in a good return. A screen based upon Mr. Lynch’s stock selection methodology is built into Stock Investor Pro, AAII’s fundamental stock screening and research database. In 2004, the Lynch screen was the top growth/value screen among those tracked by AAII, gaining 59.8% for the full year.

Evaluating the Screen

AAII tracks over 60 stock screening methodologies and reports the companies passing each of these screens on AAII.com each month. In addition, users can view the performance of simple hypothetical portfolios invested in each screening methodology that have been backtested over the last seven years.

 

Figure 1.
Peter Lynch
Screen Performance
CLICK ON IMAGE TO
SEE FULL SIZE.

Outside of the year 2002, the Peter Lynch screen has generated a positive return in each year dating back to 1998 (see Figure 1). In its sole down year, the approach still managed to outperform the major broad indexes by several percentage points, losing 7.2% while the S&P 500 lost 23.4%.

In addition, the Lynch screen has outperformed the broad indexes in every year since 2000. The year 1998 saw the worst relative performance for the Lynch screen, as it gained 1.3% while the S&P 500 gained 26.7%. Overall, the Lynch screen has easily outperformed the small-, mid-, and large-cap indexes over this seven-year period, gaining a cumulative 309.8% compared to a 24.0% increase in the S&P 500.

The characteristics of the stocks passing the Peter Lynch screen are presented in Table 1, while Table 2 lists the current passing companies. Screening criteria of the Lynch screen are listed at the end of this article.

Profile of Passing Companies

Lynch believes that finding a good company is only half the battle in making a successful investment. Buying at a reasonable price is the other half.

Price-Earnings Ratios
As an outcrop of that belief, AAII’s Lynch screen requires that a company’s price-earnings ratio be less than the median price-earnings ratio for its industry, and that it be below its own average price-earnings ratio over the last five years.

TABLE 1. Peter Lynch Portfolio Characterisitcs
Portfolio Characteristics (Medians) Peter
Lynch
Screen
All
Exchange-
Listed
Stocks
Market cap (million) $3,652.5 $130.9
Price-earnings ratio 10.3 20.3
Price-to-book value ratio 1.7 2.2
Dividend-adjusted PEG ratio 0.3 1.2
EPS 5-yr. historical growth rate 32.2% 8.9%
EPS 3-5 yr. estimated growth rate 17.0% 14.0%
Relative strength vs. S&P 25.0% (5.0%)
Monthly Observations
Average no. of passing stocks 23  
Highest no. of passing stocks 45  
Lowest no. of passing stocks 10  
Monthly turnover 22.8%  

As a result of these requirements, the median price-earnings ratio of 10.3 for those stocks currently passing the screen is half that of all exchange-listed stocks (20.3). As another indicator of value, the 1.7 median price-to-book-value ratio of the passing companies is lower than the 2.2 median of all exchange-listed stocks. Consolidated Mercantile (CSLMF), a holding company with interests in furniture, packaging and real estate industries, has the lowest price-earnings ratio of the stocks currently passing the Lynch screen, at 4.2. Foreign companies make up over half of the current roster of passing companies. These companies carry with them unique considerations, including foreign taxation on any dividends they may pay. Trend Micro Incorporated (TMIC), a Japanese developer and marketer of antivirus and Internet content security software and services, has the highest price-earnings ratio in the group, at 25.1.

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PEG Ratios
Mr. Lynch also believes one should pay a reasonable price for growth. As a rule, companies with better prospects should have higher price-earnings ratios. One popular technique to help determine a “reasonable” price for growth is to compare the price-earnings ratio to the earnings growth rate—popularly known as the PEG ratio. Mr. Lynch takes this approach one step further by adding the dividend yield to historical earnings growth, thus acknowledging the contribution dividends make to an investor’s return. Dividend-adjusted PEG ratios that are above 1.0 are considered poor, while ratios below 0.5 are considered attractive.

In order to pass AAII’s Peter Lynch screen, a company’s dividend-adjusted PEG ratio must be less than or equal to 0.5. This stringent requirement results in a median value of 0.3 for those companies currently passing the screen. In comparison, the median value for all exchange-listed stocks is 1.2.

Table 2 lists the 18 stocks that passed the Peter Lynch screen as of March 4, 2005, ranked in ascending order by dividend-adjusted PEG ratio.

The total number of companies currently passing the screen is somewhat below the historical average of 23 over the last seven years.

Knightsbridge Tankers (VLCCF), a Bermuda-based seaborne transporter of crude oil, has the lowest dividend-adjusted PEG ratio, 0.1. Five companies lie at the cut-off with dividend-adjusted PEG ratios of 0.5.

   PETER LYNCH SCREENING CRITERIA
  • Companies in the financial sector or the real estate operations industry are not included.

     

  • The price-earnings ratio is less than the industry’s median price-earnings ratio.

     

  • The price-earnings ratio is less than the five-year average price-earnings ratio.

     

  • The ratio of the price-earnings ratio to the sum of the five-year growth rate in earnings per share and the five-year dividend yield (dividend-adjusted PEG ratio) is less than or equal to 0.5.

     

  • The five-year growth rate in earnings per share from continuing operations is less than 50%.

     

  • The percentage of common stock held by institutions is less than the median percentage of institutional ownership for the entire database.

     

  • The total-liabilities-to-total-assets ratio for the last fiscal quarter (Q1) is less than the industry’s median total-liabilities-to-total-assets ratio for the same time period.

Growth Stability
A pattern of earnings growth will help reveal the stability and strength of a company and Lynch prefers to invest in companies whose earnings are expanding at moderately fast rates. However, extremely high levels of earnings growth are not sustainable and eventually the market will punish a stock price once it becomes apparent that growth is slowing. In addition, high growth rates for a company will attract investor attention, bidding up the stock price. The Lynch screen requires companies to have a five-year growth rate in earnings of less than 50%.

Despite no minimum earnings growth rate, the 32.2% historical earnings per share growth rate of the passing companies far outpaces the 8.9% norm for all exchange-listed companies.

Trend Micro (TMIC) has the highest historical earnings growth rate at 48.6%, while Korea Electric Power (KEP) is at the other end of the spectrum, with a still-respectable 12.7% growth rate.

Looking forward, analysts also have earnings growth expectations for this group of passing companies that manages to exceed those of exchange-listed stocks (17.0% versus 14.0%). As Figure 1 illustrates, the stocks passing the Peter Lynch screen have been able to generate strong returns over the long-term, and the current crop of passing companies continues this trend. As a group, these companies have outperformed the S&P 500 by 25% over the last 52 weeks, whereas the typical exchange-listed stock has underperformed the S&P 500 by 5% over the same period.

Institutional Neglect
Mr. Lynch feels that the bargains are located among the stocks neglected by Wall Street. A proxy for this is the level of institutional ownership in the company—the lower the percentage of shares held by institutions and the lower the number of analysts following the stock, the better. The AAII Peter Lynch screen requires a lower percentage of shares held by institutions than the median of all companies.

Among the current list of passing companies, Gruma S.A. de C.V. (GMK), a Mexico-based producer and distributor of corn flour, wheat flour and tortillas, has the lowest level of institutional ownership at 0.1%. On the other hand, with Mobile TeleSystems OJSC (MBT), a provider of cellular service in the Russian Federation and Ukraine, 21.4% of its stock is owned by institutions.

A by-product of the institutional ownership (or lack thereof) requirement is that the Lynch screen often isolates smaller companies. Small firms have more upside potential than large firms—small firms can easily expand in size while large firms are limited. Big companies have small moves, small companies have big moves.

The Balance Sheet: Debt Ratios
The final piece of criteria for the Lynch screen focuses on the balance sheet. A strong balance sheet provides maneuvering room as the company expands or experiences trouble. Lynch is especially wary of bank debt, which can usually be called in by the bank on demand.

Close examination of the financial statements, especially the notes to the financial statements, should help to reveal the use of bank debt. The final filter of the Lynch screen ensures that the company’s ratio of total liabilities to assets is below its industry norm. We looked at total liabilities because it considers all forms of debt. We are comparing the company’s ratio against industry levels because acceptable levels vary from industry to industry. Normal debt levels are higher for industries with high capital requirements and relatively stable earnings such as utilities.

Among the current list of passing companies, MedQuist (MEDQ), a provider of electronic medical transcription, health information and document management services, has the lowest liability-to-asset ratio of 12.0%. However, the company was delisted from the NASDAQ exchange as of June 16, 2004. The company was not current in its 10-Q and 10-K reports and is facing multiple investigations by the federal government over whether MedQuist and others violated federal laws in connection with the provision of medical transcription services.

Conclusion

The Peter Lynch screen looks for attractively valued stocks with strong earnings growth and a strong balance sheet that have yet to capture the imagination of Wall Street.

However, the companies passing this—or any other stock screen—do not represent a “recommended” or “buy list” of stocks, as the case of MedQuist demonstrates. Any mechanical filter requires further analysis—not by a computer, but by an individual.

In particular, it is important to perform due diligence to verify the financial strength of the passing companies and to identify those stocks that match your investing constraints before committing your investment dollars.

Table 2. Peter Lynch Passing Companies
Company (Exchange:Ticker) P/E
(X)
Div
Adj
PEG
(X)
5-Yr
EPS
Grth
(%)
Inst’l
Own
(%)
Tot Liab
to
Tot
Assets
(%)
Net
Cash
($/Shr)
Insider
Own
(%)
Market
Cap
($ Mil)
Description
Knightsbridge Tankers Ltd (M:VLCCF) 7.7 0.1 46.7 12.6 37.4 2.4 0 661.8 int’l oil transport
SK Telecom (ADR) (N:SKM) 8.5 0.2 44.4 21 54.2 0.4 34 14,060.30 wireless telecomm
Gerdau S.A. (ADR) (N:GGB) 5.9 0.2 21.1 4.6 63 2.5 40.1 5,834.80 steel production
FinishMaster (O: FMST) 8.8 0.2 39.5 5.1 56 0.9 54.7 115.5 auto paints
Consolidated Merc. (USA) (M:CSLMF) 4.2 0.2 25.1 5.1 31.6 1 71.4 20.5 holding co
Mobile TeleSys. OJSC (ADR) (N:MBT) 14.7 0.3 40.2 21.4 52.1 1.8 7 15,102.50 Russian cell servs
Korea Electric Power (N:KEP) 4.9 0.3 12.7 12.1 46.3 2.6 38.9 17,820.00 electric provider
Grupo IMSA S.A. de C.V. (ADR) (N:IMY) 6.8 0.3 23.3 3 46.4 1.1 55 1,579.30 industrial steel
Tomkins plc (ADR) (N:TKS) 14 0.3 43.6 3.7 48.7 0.5 65 4,273.80 global engineer & manufac
Sinopec Shanghai Petrochem (N:SHI) 9.6 0.3 31.5 0.6 42.4 0.5 84 3,031.20 crude oil processing
Toyota Motor (ADR) (N:TM) 11 0.4 23.5 1.2 62.3 9.6 1 129,277.00 auto manufacturing
MedQuist (O:MEDQ) 12.9 0.4 32.9 11.5 12 8.1 24 513.6 health info servs
Canon (ADR) (N:CAJ) 14.4 0.4 37 3.5 38.4 3.9 69.9 47,464.60 copiers, printers, cameras
Gruma S.A. de C.V. (ADR) (N:GMK) 14.2 0.5 29.2 0.1 57 2.4 24.9 1,154.00 flour & tortillas
Southern Peru Copper (USA) (N:PCU) 13.4 0.5 17.3 16.1 32.2 3.9 41 5,137.10 copper producer
Bio-Logic Systems (M:BLSC) 20.7 0.5 43.1 10.6 24.1 5.2 54.5 41 electro-diagnos sys
Noland Company (M:NOLD) 9.4 0.5 18.2 5.9 41.6 1 73.4 174.1 plumbing & ac supplies
Trend Micro (ADR) (M:TMIC) 25.1 0.5 48.6 0.2 40.8 0.4 80.8 6,246.80 antivirus software

Exchange Key: N=New York Stock Exchange, M=NASDAQ National Market or NASDAQ Small Cap Market, O=Over the Counter

Source: AAII’s Stock Investor Pro / Reuters Research Inc. and I/B/E/S.

Data as of March 4, 2005.

Wayne A. Thorp, CFA is a vice president and senior financial analyst at AAII and editor of Computerized Investing. Follow him on Twitter at @WayneTAAII.


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